by Bob Andelman

It's hard to imagine that a beer company could ever be anything but consistently profitable. Did anyone notice a slackening in America's thirst for hops and malt? Is it really possible to over-estimate our need for a tall cool one?

But Anheuser-Busch ­ producer of the Budweiser, Bud Lite, Michelob and O'Doul's brands ­ was a notorious disappointment for years before turning its ship around in the late 1990s. Prior to that, management over-promised and then would gradually reduce expectations throughout the year. That made analysts nervous that it was overly optimistic and not conservative enough in its projections. It created uncertainty.

PepsiCo went through a similar, almost simultaneous period of volatility in earnings. It made bad investments overseas and pulled out of unprofitable countries. It got out of the restaurant business (spinning off Taco Bell, Pizza Hut and Kentucky Fried Chicken into Tricon Global Restaurants). It also reorganized its bottling operations into a separate business, much as Coca-Cola did several years earlier.

There was a great deal of confusion over and at PepsiCo; uncertainty and lack of confidence in management and earnings prevailed for some time. But management regained its focus on soft drinks and snack foods (see Chapter 1, "Sustainable Management" for details) and worked hard patching up confidence on Wall Street and with individual investors.

Smart Decisions, Fat Profits

On Wall Street, no one really cares about what a business did yesterday. The game is all about what it will do tomorrow. It is the nature of a company and the stickiness of its business that gives it a sustainable growth rate. It is easy to find companies that are growing rapidly today. Finding companies that will continue growing rapidly year after year after year is difficult.

Industries go up and industries go down, but there are profitable companies within every industry. The range of profits, of course, varies widely. Profitability is about execution, and finding organizations and people who are making smart decisions and heading in the right direction.

"There just aren't many good companies," says Phil Dow, an equity strategy director at Dain Rauscher Wessels in Minneapolis. "Rather than be a trader who is in when the sun is shining and out when it's cloudy, I want to own superior businesses because they tend to endure. What I have found is that while I have certainly had my share of ones that were wrong, I have had my share of winners, and the winners make a huge difference."

When Dow was a director of equity marketing at Piper Jaffrey, the firm had roughly 1.5 million shares of Cisco with an average cost of 75 cents. "So I didn't give a s--t that it went from 82 to 37," he says. "I didn't like it, but in a recent five year period, Cisco fell 50 percent twice yet recovered back."

The benchmark of a profit-driven investor is that that person focuses on the same thing an entrepreneur does, financial guideposts, not price. A good business owner doesn't focus on what his business is worth hour by hour. He is more concerned about the revenue line, what he can do to assure reasonable margins, and what will grow the enterprise. If you focus on those same things as an investor, you will be more measured, less emotional and more profitable.

The ability to find profits is key.

A company need not be profitable when you invest in it, analysts say. But they do want to see how it will turn a profit. The average individual investor looks at companies in search of consistent earnings. He or she doesn't want companies that are all over the board from month to month or year to year.

How can you discover whether a company is consistently profitable?

Read a company's own quarterly reports, 10Qs or annual reports. Most now publish them online, or will send them free of charge upon request. You can also read publications like Value Line and Morningstar, as well as independent, industry-specific newsletters or general interest business publications such as the Wall Street Journal, Investor's Business Daily, Forbes, Fortune, The Industry Standard, Red Herring, Worth, Smart Money and Business 2.0. Additional recommended sources of historical information include the Electronic Library (http://www.elibrary.com), Yahoo! Finance (http://finance.yahoo.com) and Hoover's Online (http://www.hoovers.com/).

Your goal is the construction of a historical model of the company's earnings and how its performance regularly matches up with expectations.

Fine. But how, you ask, does a company sustain earnings growth in a slowing economic environment? By becoming more efficient. In a rapidly growing economy, you don't really have to look for those ways. Management can hide a lot of mistakes when the top line is growing rapidly. It can't hide those mistakes when things slow down, and then it should address them more aggressively.

When things get tough, technology gets more attention. There will also be more attention paid to inventory growth levels and shortening the supply chain, which gets back to the use of technology.

If the expectation was for five percent growth at the beginning of a year, maybe that growth will be closer to three percent, for example. Expectations will ratchet downward, bringing down inventory levels and payroll hours to match that slower rate of growth.

Cash is King (Trump That!)

Question: Does the business you're considering generate positive cash flow?

There are two types of risks you can take in a stock: Operating risk, which is the risk of the business it is in, and there is financial risk, which references the way a company is capitalized.

The operating risk is something that we all take. It's all about how good the business is, and what is its future? But you don't have to take financial risk. Financial risk is taken down to a minimum when you buy companies that generate excess cash flow. If they generate excess cash flow, they can raise the dividend, buy back their stock, and make acquisitions in key times when others can't. When problems develop, a company with positive cash flow doesn't grasp at short-term strategies, which are not in the long-term interest of the company.

Everybody wants to acquire companies that generate excess cash flow.

"My first advice to the individual investor," says Robert A. Olstein, co-founder of the "Quality of Earnings Report" in 1971 and president of Olstein & Associates in Purchase, N.Y., "is to look at the company's balance sheet and see if its cash is going up or its debt is going down."

Both are positive factors.

"Our rule of thumb here is only buy a company that, even if it has debt, it can pay it off with cash flow in five or six years if it chooses to do so," Olstein says. "For example, we bought a company called Santa Fe Drilling (Santa Fe International Corp.) back in 1998 at the height of the oil crisis. Oil was down to $10 a barrel. The reason we picked Santa Fe ­ and we wound up tripling our money in a year ­ is because even in bad times, it was generating excess cash and it had no debt. So if our timing was wrong as to when it turned, we weren't going to get put out of the ball game through a bankruptcy or anything."

Follow the Money

Distributive computing, laser technology and fiber optic cables have broken down the old financial structure of the Western world and replaced it with something almost unrecognizable. Think about it: Most payments being made in the United States no longer go through the traditional banking system.

We have a whole new monetary system out there. Funds flow in a totally different direction than they did thirty years ago. We have a whole new method of handling payments for those fund flows that didn't exist thirty years ago. Who wins? Who loses?

Maybe you do.

It goes back to finding businesses where there are barriers to entry and/or where there are economies of scale. People generally think the credit card business must be super price competitive, and yet if you look at return on equity of the leaders, it is actually a high-margin business. MBNA's return on equity is approximately 25 percent a year; that is a high-margin business. It is hard to find businesses with 25 percent return on equities, especially a company with a $30 billion market cap. But there are economies to scale in the credit card business.

The mono-product companies such as MBNA or Capital One are huge winners under this system. They get control of the payment system, and they don't need banks to get money, they just securitize product and sell it into the open market. Fannie Mae and Freddie Mac win. The mutual funds win. The whole structure of how you do business in the financial system is dramatically changed.

What about the banks? What will they do? How do they get back in the game if in fact they are not the high-cost producers?

It comes back to thinking about what will be the structure of how people will buy things. If the lesson of the Internet is that we have moved power away from the producer of the product to the buyer of the product ­ because there is an infinite amount of information available to the buyer to make a decision ­ how do the banks operate in that environment?

We do know that somebody out there wants a banking product. We don't know what the banking product that he wants is. We don't know when he will buy this banking product. We don't know where he will buy this banking product. And we don't know what price he is willing to pay for it. So we establish a distribution system that gets him at the point in time that he will make that decision to buy, for the product he will buy, at the price he is willing to pay, at a location where he is willing to make the purchase.

Imagine the mechanism that allows yesterday's bank to not only survive but thrive. Imagine a system that allows a customer to be named later to bank at a branch, at an ATM, on the telephone, on the Internet, in a supermarket, in the auto dealer's shop, in the real estate agent's shop, basically anywhere in the world through use of a debit/credit card. That is a flexible, consumer-oriented distribution system. It captures the customer buying a beer or a Buick.

In order to build that distribution system, banks can't manufacture their product in their accustomed fashion ­ slowly, that is. If they can't approve an auto loan in fifteen minutes or less, while the customer is literally standing around the Chevrolet or Nissan showroom, they've lost that business.

"As an analyst, I sit back and think, can this comprehensive system work?" says Richard X. Bove, director of financial institutions research at Raymond James & Associates in St. Petersburg, Fla. "I think it can. But who provides the inputs to that new system? It could be a growth business."

Did you see that one coming?

Fiserv, for example, provides the back office processing so that banks can answer loan questions in fifteen minutes.

Get it? This wasn't an anti-bank rant; it was a pro-whoever-is-forcing-the-banking-industry's-hand rave.

As you see structural changes occurring, you should position yourself with whoever benefits by the structural changes. Who benefits because there are now $15 trillion of Euro currency out there versus $110 billion thirty years ago? Merrill Lynch benefits, and so does Morgan Stanley Dean Witter, because the capital markets function will become increasingly importantly. Who benefits because someone must make instantaneous decisions on consumer loans if they are to get that business? Anybody who has inputs to that system does! Who benefits if the payment system is restructured so that companies can get control and reduce the cost of payments? The credit card companies.

Assess the macro-developments in an industry. What change is being forced upon it? Who wins and who loses as a result of this change in function and structure?

There is criticism here and elsewhere that too many companies saw the Internet as Easy Street and paid a stiff price for it. But the medium itself continues growing even as some of the pioneers peter out. And behind all the Wizard of Oz pyrotechnics is the need for electronic exchange ­ the interactions, the transactions ­ and that part of the Web is growing like Georgia kudzu. While all the customer-centric stuff shakes out, the transaction backbone is thriving.

It is pretty evident that the Internet has been a massive success. The success has only begun, and it will be greater than anyone ever imagined even a year ago or two years ago. What is different is that the pioneers who opened the markets didn't have the staying power. They didn't have the customer bases or the capital to take full advantage of the new technology. They flashed because they were the first users of the system, then they burned because they couldn't use it effectively. But EDS and Citigroup and Bank of America will integrate Internet operations into their business on an increasing basis going forward, and therefore, the use of the Internet will explode from this point on.

The profitable investment to consider is straight from the mouth of Willie Sutton: Go where the money is. But old Willie wouldn't recognize the "where" anymore: Backbone services and infrastructure. Citigroup and Bank of America are not using the Internet to gather new customers. They are using it to lower their cost of doing business. So are the bulk of the B2B (business-to-business) companies making use of it. Many of the recent dot-com companies didn't have the capital necessary to play the game from beginning to end. The big companies do.

"I can't think of anything negative to say about the Internet," Bove says, "nothing negative about where it is going, or how it is functioning, because it is all working out magnificently well. It is just not working out for the pioneers; it is working out for the companies that have the customers and the capital."

This is not at all unusual in the business world; in fact, it's the way we expect things to happen. We expect the innovator to go out there and prove the viability of a concept, system or idea. Then we expect one or two of those innovators to stay around, while the bulk of followers come not from other innovators but from the companies that are in traditional markets.

Don't believe it? Who do you think made all the money during the Gold Rush? The tens of thousands who went off in search of treasure or the people who bought property, rented out rooms, prepared hot meals and sold shovels and pickaxes? You were better off selling shovels than digging for gold.

Bring It On

At most investment firms, stocks are classified according to different criteria for tracking purposes. Below, Bill Fries, a portfolio manager at Thornburg Investment Management in Santa Fe, N.M., and David L. Babson Company large cap value fund manager Tony Maramarco, who is based in Cambridge, Mass., take us through their firms' unique vetting processes to determine profitability.

In each of three classifications, Fries looks for a different characteristic for profit potential.

o Basic Value Stocks

These are typically mature, cyclical companies. A basic value stock, because of its economic cycle, may have high returns on equity at some point in its cycle. But at other points, it may actually operate at a loss. Or it may not have high returns.

"What I would look for in those companies when they are having or moving toward losses is a stock selling at lower multiples of book value," he explains. "The profitability characteristic that you look for here is not one of high profitability but one of improving profitability."

One company in this category might be Boeing Aircraft. Fries concluded that while its profits weren't going to be dramatically high in terms of return on equity, it would improve. And because the stock was depressed, that provided an opportunity in the market. That's a typical basic value approach. In other words, try buying a stock at the right time in the economic cycle, taking advantage of what is temporary negative psychology.

With basic value stocks, you would ask yourself a number of key questions. How much worse can it get? How much more depressed can the stock get? The fundamentals and the psychology in Boeing's situation are probably as bad as it can get, Fries says, "and that is usually a pretty good time to be buying those companies. We are talking about improvement rather than absolute high levels."

o Consistent Growers

Blue-chip companies are found in this category. They exhibit high levels of profitability in industries that are not particularly cyclical. They typically enjoy more stable demand for their products and at stable pricing.

Kimberly-Clark is a consistent grower, selling consumer products that we use every day such as tissue paper, paper towels, infant and adult diapers. It is not a particularly cyclical business in terms of the unit volumes that are produced. Kimberly-Clark and Proctor & Gamble compete brutally for market share, so there is frequent pricing pressure. But the business has high profitability, returns on equity well over 25 percent, and a consistent business model.

"There we are focused on the capital returns, the profitability of the business and the consistency," Fries says. "We would not be looking at the cyclical, and we pay a lot of attention to what we pay for that stock. I think everyone that is involved in the investment business recognizes that Kimberly-Clark has a solid market position and has executed well. It becomes a question of what you are willing to pay for that stock, even though you recognize that it is a promising company."

Profitability becomes more complicated at this point, because there are so many economic factors upon which to focus. These include how much you are being asked to pay in terms of the current multiple, compared with Kimberly-Clark's past multiple, or its price to sales ratio or the price to book ratio and the dividend yield.

o Emerging Franchises

These are more aggressive, more growth-oriented, newer companies.

Emerging franchises are altogether different from basic values and consistent growers. There is not nearly as much certainty in the emerging franchise business model. These younger companies typically demand a great deal of time as investors learn the business and decipher their business model. How will they generate revenues? What are the critical variables of those revenue generation characteristics? Can you make a judgment based on what you learned or do you need more information?

Emerging franchise companies typically start with a pretty narrow spectrum of product or service. Before you can really make a sound judgment about whether it is a promising and good quality company, you should make some judgment about the space that they serve in the market.

Some of these companies won't be profitable at the time that you get involved in the business. They typically grow at fast rates, so pay attention to the growth rate of the industry, as well as the growth rate of the particular company. Pay attention to the details of their market niche. Because these industries are not well established, sometimes you won't know which of five competitors will be the survivor.

Make fewer presumptions about the quality of the management. With an established company like a Kimberly-Clark or Caterpillar Tractor, the business organization has been in place for several generations. With an emerging franchise company, it is creating a corporate culture, an organization and the ability to management it all on the fly every day.

Keep a watchful eye on the emerging franchise's business model. Microsoft ­ what a great business model and one that an entire industry copied with mixed results. It creates software programs one time, packages it, the margins are enormous and sells it many times over.

That's one approach. Value fund portfolio manager Tony Maramarco has another.

"We take a universe of stocks, the Russell 1000 Index, and we screen it for five value factors and two growth factors," he explains. "The reason we have growth factors in there is because we are a particular type of value managers who want to avoid falling into what we call the value trap, which is buying stocks simply because they are cheap."

Value managers are notorious and known for buying things when they have fallen in stock price, but the growth screen factors allow Maramarco to be as sure as he can that the stocks he looks at have shown some kind of a rebound. He doesn't want to just buy it and have it sit there as cheap stock.

As a portfolio manager, Maramarco follows a bottom-up approach to fundamental analysis. He spends a tremendous amount of time looking at financial statements, balance sheets, income statements, and cash flow statements.

Here are Maramarco's five value metrics:

o Quality of earnings. This is determined by a reading of the company's earnings statement.

o Changes in shares outstanding. If a company is buying back its shares on a net basis, not just simply buying them back so that it can then put them out in stock options for officers or employees of the company, look for a net reduction in shares outstanding as a screening factor.

o Consensus estimates and individual analyst's sell-side estimates to see if they are going up or down; Maramarco calls that "estimate diffusion."

o Capital expenditures and depreciation. What is the relationship between those two factors?

o Cash flow to price.

These are Maramarco's two growth metrics:

o Price momentum, 13-18 months previous to the present date. Look for a declining stock price on a relative basis.

o Price momentum, two months to twelve months previous. Look for some kind of a general strengthening of stock price.

Maramarco says that in his experience, price momentum of 13 to 18 months previous and price momentum of two to 12 previous have proven to be good indicators of future performance for value stocks.

After subjecting the Russell 1000 to the seven variables above, Maramarco slices all 1000 companies into 10 deciles, with the top 100 stocks being in the top decile. Those will be the most attractive to him for purchase based upon those screening factors.

The vetting process is not over yet.

"We will then concentrate on the top 100 or the most attractive based upon the first screening procedure," Maramarco says. "Then we will take a look at those stocks and screen them one more time, using eight different but more traditional value variables. Three of them have to do with the price to earnings ratio, three of them have to do with price to book ratio, one of them has to do with dividend yield, and the last one has to do with price to sales."

Numbers give many people more confidence, so between Fries and Maramarco, you now have at least two methods of comparing and contrasting the profitability of a stock. Neither way should be viewed as the last word, merely another device for rooting out possible winners from possible losers.

The screening process says, "State what is generally important to you, and it will mechanically, through the miracle of computers and software, rank companies for you based upon what you tell it." The output from the screening process will only be as good as the input we give it or the questions you ask.

Investing ­ after you go through the science of the computer screen ­ is an art. There is no other way to put it. There is no black box, there is no magic formula, there is no silver bullet. Often times, it comes down to your gut and what your gut is telling you based upon experience.

Consistency of Eatings

The first three characteristics that Peter Tuz, a vice president of Chase Investment Counsel, Charlottesville, Va., looks for in a company are growth period, earnings and revenues. He likes to see that in at least seven out of the last ten years, a company demonstrated increasing earnings and revenues, and if possible, both at a greater than 10 percent rate. High profitability is measured by the company's return on equity (ROE). And these factors must be examined more closely.

SYSCO, the Houston-based food service company, is the leading distributor of food and related products to the food service industry in the United States. You have eaten its products probably thousands of times. But if you go back, the company has basically grown earnings and cash flow per share since 1984 and revenue since 1990. That means 10 years of growing revenues and seventeen years of consistently growing earnings.

Why is that happening for them?

Two main reasons. Consolidation in its industry is one. SYSCO has also benefited from the continued growth of the food service industry as more and more people eat more and more meals out.

Of every dollar spent on food, 50 percent of it is now spent outside the home, outside the grocery store. The main thing SYSCO did was acquire other companies that it folded into its business, increasing the number of items that it might sell to a restaurant. That increased its margins, because it delivers 10 boxes to a store instead of three. A lot of SYSCO's products are now branded versus it just being a distributor of other peoples' products. That is a higher margin business. It increased its margin per customer at a big rate.

SYSCO'S ROE has ranged from a low of 17 percent to a high of 26 percent. It is the kind of a company that hits singles and doubles; a consistent .300 batter in baseball terms, one that doesn't hit many home runs or strike out often.

Another characteristic noted by Tuz is how much of its earnings SYSCO retains versus how much is paid out in dividends.

"Going against conventional wisdom, we like to see a company with a good growth record retain as much of their earnings as possible," he says. "SYSCO has a high retention rate, so their ability to grow without accessing the capital market is high compared to a lot of companies."

The Future's So Bright . . .
I Better Get My Eyesight Checked

When you invest in a company, don't think that you're investing in today's profits. You're investing for a share of its future profits.

Start by choosing a company in an industry where there is a future. Architectural drafting supplies may not be a smart choice unless it's computer-aided-design (CAD) software. You want a company where the industry has a bright future for developing additional growth revenues.

The do-it-yourself retail industry, for example, has been an industry of significant opportunity for the past 20 years with little sign of slow down.

The reasons are basic but clear. As the American economy improved and the population aged, people became more and more interested in their home environment. The home-building industry is known for having a high degree of cyclicality based upon what is happening in the economy. But the do-it-yourself (DIY) industry has had measures of counter-cyclicality. When people move into new homes, they find endless reasons to go to a hardware store for months. On the other hand, when the economy turns downward, people take a greater interest in their home environment: "I will fix up my existing home and make do with where I am as opposed to moving into a new house." They might build an outside deck or re-do a kitchen or replace some floor or window covering. The DIY industry has really benefited and seen what would be considered above-average growth over time.

Another industry on a profitable upswing in recent years is office furniture. Not as sexy as consumer electronics, perhaps, but it has benefited from several factors:

o The growing interest of employers in ergonomic design.

o Remodel necessitated by the arrival of the personal computer. As recently as the early 1980s, there was not a tube on every desk. Now there is, and that has wiring implications. With the possibility of wireless networks in the near future, another generation of renovation and adjustment may be in the offing.

o New laws ­ and a raft of employee lawsuits ­drove to work the notion that if you spend eight hours a day in an office chair, it should be good for your back.

o And as the employment market for white-collar employees became tighter in recent years, some companies used the ambiance of their office to attract employees.

All of the above made employers take a greater interest in their office environment. Meanwhile, office furniture companies such as Herman Miller and Steelcase capitalized on all the upheaval. The entire industry benefited and has grown at more than 30 percent since the late 1970s and early 1980s.

When you settle on an industry that is growing, whether it is DIY, office furniture or something else, look for good companies in that industry.

The DIY industry has a leader ­ The Home Depot ­ that started in 1979, and it wasn't much of a secret that this would be an interesting company because Depot operated in an interesting way. Depot focused on essentially a couple of things: Taking care of the customer and killing the competition. It has lots of skin in the game, it plays the game hard every day, and it never took the view that it had all the answers. It knew that every day was a new challenge, so it has been an interesting culture to watch, one of the most successful start-up companies ever.

In the office furniture industry, Herman Miller and The HON Company learned to better deal with some of the challenges in their industry. They became good investments because they had high profitability and high returns. And what the market will ultimately pay for is just that, converting opportunity.

There is never any lack of good ideas. But an idea should be executed and executed consistently to become a good investment, because what the market ultimately pays for is some present value of future free cash flow generation, and that is ultimately what something is worth. Analyzing that and understanding where to buy that is a big trick. It is a simple concept but hard to execute.

Can You Get to Three?

There are many ways of breaking down profitability potential. Gary Balter, a retail analyst and managing director of Credit Suisse First Boston in New York City, breaks down the stores he follows into qualitative and quantitative characteristics; he says that the quantitative factors are the less important.

"We look for companies that can drive strong return on invested capital from a quantitative point of view," Balter says. "There are three specific measures that we look at for our companies. One is sales per activity, second is operating margins at the store level, and the third is inventory and turnover."

Said another way, if the company efficiently manages its assets, it is a good company in Balter's book. And the company that drives the highest return on investment (ROI) at the store level is also likely to be a good company.

As an example, Balter offers a comparison between the two leading do-it-yourself home stores, The Home Depot and Lowe's Home Improvement Warehouse. The Home Depot stores average $45 million annually per store; Lowe's averages $32 million per store. They have roughly the same inventory turns (5.0 to 5.1; this is the cost of goods sold divided by the average inventory for the period, another way of saying how much inventory is required to sell a good), but The Home Depot's overall, pre-tax operating margins (this is EBIT, earnings before interest and taxes, or a way of measuring how the business operates ex-financing costs and taxes) are 9.2 percent, and Lowe's are 7.5.

"Where would you rather have your money?" Balter asks. "Same business, same opportunity, same size store, same investment in the store."

He's not saying Lowe's is a bad company by any means. It is actually a good company. In the short term, you can make money with any stock if you time it right. But if you are looking for a long-term company to be invested with, you should start measuring which ones can be the most productive users of your capital. And those are the ones that tend to win because there is always a point in time in the equation where capital gets constrained. The Home Depot, for example, will use the fact that Lowe's is getting more leveraged to squeeze them in pricing or some other measure. Lowe's is a smart company. Lowe's is a great company. It is just not as good as The Home Depot.

In a young company, Balter doesn't care about current profitability so much as the profit potential in the concept. Will it jell as the company matures?

When they get too big, if they are not profitable, he doesn't want them, either. And the leader isn't always the best one. That is one of the lessons we learn all the time, because otherwise analysts would still be recommending Kmart.

Choose the company that drives the best underlying numbers, which is another reason sales per square foot is an important measurement in retail. And sometimes it doesn't equate to profitability because it is so young in its concept that it is driving good store operating profits, but the expenses of ramping up are so high that it is not really making the earnings.

Products, Price and
Some Other 'P' Word

What you want to see more than anything else in any company that you consider is its ability to increase two things. One is the number of customers with whom it does business. Two is the number of products it sells to those customers.

You want unit sales growth. And obviously, unit sales growth emanates from those two sources. From a secondary standpoint, you want to know that the profit margins on the products that are being sold are moving in a positive fashion, hopefully expanding but at least substantial. You are not really looking for anything beyond those two things, so all of the analysis that you do should focus on determining if you can get unit growth and whether margins will be high or low.

Let's assume that you paid $400 for your last new television set. Every time you wanted to buy a television, you went down to the corner store, paid for it, then brought it home yourself or paid a fee for delivery. If someone all of a sudden came to you and said, "I will sell you that television for $8 and you don't have to go to the corner store. We will deliver it right to your home at no charge," you could imagine that the sales of televisions would explode. Well, that's what E*TRADE did.

A trade at Merrill Lynch once could cost hundreds of dollars. E*TRADE appeared and did it online for $15; Ameritrade for $8. It changed the metrics of the industry in such a fashion that investors could be assured that there would be an explosion in the number of customers bursting through their virtual doors.

The second issue that then arises is this: Can E*TRADE sell multiple products to its customers? E*TRADE argues that is happening, but if you look at E*TRADE's figures, they show small investors who can't spend a heck of a lot of money in the stock market. Therefore the potential for unit growth at E*TRADE beyond price-cutting does not appear great.

Price cutting at such a company attracts a great number of customers, but margins are tight. The company won't make much money on them. Maybe they don't fit our key metrics: Number of customers and number of products.

So much for a one-trick pony. Let's approach the metrics another way.

If you are looking at Bank of America, you might ask different questions. What is the growth of the American population? What percentage of that population can BoA garner? What products is it able to sell to that population?

Now look at factors beyond BoA's control. Where is it in the cycle? Will the Fed increase interest rates? Are loan losses going up or down? Again, we're taking a turn into more complicated decision-making that requires studying a number of macro-factors.

What are the core products being sold by Bank of America? It sells mortgages, auto loans, and deposits. But its core products are all better sold by other companies because the nature and structure of the banking industry is changing. If you want mortgages, you go to Fannie Mae and Freddie Mac. If you want auto loans, it's General Motors. Personal loans? Try MBNA or Capital One. Deposits? There are any number of mutual fund companies such as Fidelity Investments.

Then you should ask yourself, "Well, how can BoA increase the size of its units sold if it is the high-cost producer of everything that it sells and if the companies it is competing with tend to sell these products at much lower prices?"

Layer after layer after layer, try and come to a conclusion as to whether there will be more customers buying more products. That is what you must learn to decide whether or not the company can deliver.

The value proposition can be equally dicey in a one-trick pony or in a megalith. That's why the fortunes of the richest and the poorest of investors rises and falls daily.

Read the Graffiti on the Wall

Companies need a direction. They can't just rest on their laurels. The delay between setting the direction and realizing the rewards can be some time. Companies that are not doing so well may not see it. Many companies hire consultants when they see the symptoms of a problem, before the market even sees it, before the customers even see it. Those are the best companies.

Those are the companies looking beyond just profit, which is what the outside world sees. They are looking at things like market share and their present ability to provoke new businesses, products, or whatever defines them. And they are looking behind the scenes at the less public material.

Management's responsibility is ensuring that the business keep doing what it is doing correctly and profitably now, at the same time it looks to the future.

One of the biggest issues is a management that is just running the company, being comfortable being management of the company, not looking to where it is going, not looking at symptoms or indications of future profitability, not preparing for the next war. Companies are often preparing for the last war, meaning the last issue that confronted the company, believing that the future one will be just like it, and it may not be. Maybe the last one was about technology and the future one is about people.

Reality Options Bite

Profitability also stems from implementation, competitive environment, and other factors.

Look at the balance between a company's business options and the obligations it already incurred. If you account for differences in price earnings ratio, what makes the difference between General Motors and Cisco or Palm and a biotech company? The answer is that the highly valued companies have real options. There are many things they can possibly do, and few constraints on their activities. A real option is something that the company could implement or pursue but to which it is not obliged. If a company has options and is not encumbered by many fixed obligations such as plant network or labor contracts, then it may have a delicious recipe for generating future growth.

Two things generally drive stock price: one is a company's current earnings and another is its expectation of future earnings and their consistency.

Palm and Cisco, because of technological change, culture and their capabilities have many ways that they could grow their companies and they have few obligations. Both are close to virtual companies. They contract out much of their manufacturing, and they keep lean organizations.

Contrast that to GM. Its few options are shrinking further even as you read this. It has: fixed plants; union contracts that commit it to expensive work practices; and agreements with dealers that handcuff them. So it is not surprising that GM doesn't get a good price/earnings ratio.

Another consideration is a company's competitive environment. Who is the competition? What are their plans? Competitive context means a lot. A company's capacity to implement its strategies is really all about leadership, structure, capabilities, and the ability to bring on the right kinds of people. Is the company an attractive place for people to come and work, to be excited about? Are employees highly motivated? Motivation is a function of growth opportunities.

The problem is not that there isn't enough readily available corporate information. When it comes to data, opinions, reports, analyses, and so forth, we are awash in the stuff. There are industry studies, analyst reports and news stories galore. The problem is sifting through all the drivel so you can come up with something that is reasonably credible.

It is more a case of asking the right questions and being properly suspicious of the source of an opinion. Some people heavily discount analysts' reports because many have a huge stake in the investment banking business that funds the companies it follows. Some are employed to be research analysts at the same time as they know they must write favorable reports in order to get the follow on investment banking commitments. Anybody that has a self-interest in the information should be discounted.

On the other hand, there is objective information to be found in analyst reports on what these markets are doing and what the competing technologies are, who the competitors are, what they are doing. You can go to their web site and learn directly from the companies. This is where applying good judgment comes in. You can read all this material, but if you don't know what questions to ask, you are still in trouble. You will get buried in a Niagara Falls of conflicting information.

Then there are the financials, and you should learn how to read them to make sense of a company's current profitability. Is it inflated or biased? Going back to the distinction between options and obligations, if a company has huge lease commitments, that is a real anchor on its ability to move quickly, so you should take that into account. That is an example of being able to read the balance sheets or, more accurately, getting to the footnotes.

When It Absolutely,
Positively Has to Be Profitable

A company's obligations set in concrete what its future profitability will be because if it has those obligations, it can't spend on acquisitions or R&D. It can't do this, it can't do that. In order to make money, the heavily obligated business must first and foremost get more capacity from its existing network, labor, physical plant and equipment. It reduces the company's ability to grow and have the resources to explore new areas. Not that it won't try ...

FedEx has financial obligations, but lots of options and opportunities. GM, on the other hand, is severely restricted. An automobile plant might be able to switch from making station wagons to SUVs, but that's about it. Fed Ex, on the other hand, can use its network in a variety of flexible ways. So it is an obligation in one sense, but it is also a platform on which it can do different things. Think of obligations as being fixed constraints. FedEx has a number of things that it could do with its delivery system, including manage other companies' spare parts inventories for them. They say, "FedEx, we want you to take over our warehouses for spare parts and be responsible for delivery activity. And as soon as we need a part in Oshkosh, your job is to get it there as fast as possible."

Most business obligations center on labor contracts, but in certain industries Superfund legal problems may be the obligation from hell. An extreme case would be Owens-Corning, which is technically bankrupt due to $15 billion in pending lawsuits for asbestos damages. Owens-Corning dealt with that by declaring bankruptcy.

Highly innovative organizations such as Cisco gain latitude for identifying and integrating appropriate acquisitions. It has certain skills that it can apply. Options are created out of the resources a company possesses, the skills it can apply elsewhere.

Once a company's options are weighed against its obligations, the next big question is, what is the competitive setting?

Montgomery Ward was actually a competent merchandiser. Competent, not outstanding. JCPenney and Sears are the same way. These are good organizations. They do their jobs well, they keep their costs down. It is just that they have some competitors that are that much better, and they are getting killed by Target and Wal-Mart. Montgomery Ward waving the white flag was a recognition that there is a changing retail environment and that its competitors are simply better positioned.

Sears follows what once was a successful business model, but it got caught between the power discounters, the big boxes, and the specialty boutiques. In clothing, it is always trumped on style by operators such as Talbot's and the high end of fashion, and at the low end it gets beaten on price by Wal-Mart.

Sticky Business

If you can find the next Microsoft, that's great, but you can also make money by finding well-run companies in non-sexy businesses that execute well and make money over the long term and with less risk.

Give America Online your credit card number and every month it will dent your account for $21.95.

Need a storage unit to hide all the stuff overflowing your garage? The owner is only too happy to electronically debit your checking account on the first of every month for $66.

Does your business rent uniforms or outsource payroll functions? If so, it writes a check, month after month, to a service provider.

Analysts have a nice phrase for these recurring, painless charges: sticky business.

The key to profitability is the people running the show.

"Paychex is one of the best business models I have ever seen, if not the best," says David Farina, a principal and securities analyst specializing in technology at William Blair & Co. LLC in Chicago. "It has a wide open market. We have, in this country, 10 million-plus small businesses. Paychex works with about 370,000 of them. It keeps adding small businesses, and then it sells them more services, expanding its margins for an incredible period of time. It not only has good top-line growth, but it has a pretty impressive margin of expansion as well."

Paychex is an amazing, little-heralded profit story of 33 percent per year growth for the last 10 years. It is run by a strong management team. It plays in an enormous sandbox, and it generates a recurring, predictable pattern of revenue.

Anybody with reasonable intelligence would get the Paychex model right away. It is not complicated. The average Paychex client has 14 employees. The company grows its sales force at 10 percent a year in the belief that it can grow its client base at least 10 percent a year. Then it sells more services and products into its existing client base, adding another three to six percent from incremental product sales. Every year prices rise a little. And because this is a fixed-cost business ­ printing checks and running computers ­ its cost of performing the service goes down every year because the computers get cheaper and its infrastructure is fixed. Add that all up and you get a company that has grown margins faster than revenue for a long time.

Paychex administers direct deposits, which amount to more fixed-cost business. Once it built a basic system for electronically moving money around, moving more and more money didn't cost any more. And the same thing with the 401k account management it does. It manages peoples' 401ks, not the actual money but the administration of it. The incremental cost of management is low. The same model is applied to paying taxes for Paychex' small business clients, another sizable but fixed-cost in which the incremental revenue is profitable. So if every year Paychex adds more revenue, it adds even more profits.

Good management is important to the profitability of the Paychex business model. Could bad managers have made the same model as successfully?

It's doubtful. Farina says there are a thousand payroll companies in the United States, but only three or four of them are successful. It is an execution business. Management must do a lot of little things well.

Think about it. The essence of the business is producing an employee's paycheck that is accurate, correct and painless for the employer. If the processing company messes it up, employees and employers won't be happy. Mess it up twice, and in the competitive environment, the client won't think twice about finding another provider. There is no room in the equation for "Oops, the printer didn't work," or "Oops, we had the wrong amount." Sure, mistakes happen, but the tolerance for errors when you are talking about peoples' money on payday is extremely low, and it is unacceptable to not do it right. The fastest way to an unhappy work force is to mess up its payroll.

Taxes are paid from payroll, benefits are derived from your payroll, loan payments, alimony and child support garnishments all can come out of the payroll process. Paychex makes money on all of it.

Its additional services include administering health care plans and Worker's Comp insurance. It can deliver paychecks to an employee debit card. It can even take over the entire HR function at a small company.

Paychex' daily business is about blocking and tackling well, executing on offense and defense, creating new customers and introducing a steady stream of new products and services. "It just runs a damn good company," Farina says.

After 30 years in the business, Paychex has a long way to go. It swims in a big market, the kind where slow and steady wins the race. "You find somebody who can grow that fast for that long, it is a monster, an absolute monster," Farina says. "And they are very rare. Incredibly rare."

Automatic Data Processing (ADP) is another diamond in the payroll business, the granddaddy in the industry. It boasts a long streak of double-digit earnings, going all the way back to the 1960s. That's 160 quarters and counting.

One of the main reasons that these companies exist and thrive is courtesy of Uncle Sam. The government creates incredible layers of bureaucracy for business. If a company employs anyone under the age of 18, it must file under child labor laws. Then there are all kinds of overtime rules and laws about this and that, and legislators are always changing them. In the state of Illinois, for example, when a business hires a worker, it must send a note to the state saying the person was hired and what their Social Security number is. The State does that to track immigration, and to enforce work force rules. That's the law; if a business doesn't do it, it gets fined. And every state has its own laws and regulations.

In the city of Chicago, a business could be responsible for paying taxes to an array of different tax authorities including the city, the county, individual townships and municipalities, and the federal government. Then there are the employees who work in Chicago but live in Indiana, Wisconsin or Michigan. That is an enormous burden on a small company. And a lot of those reports must be filed electronically by law. That's too much of a burden for the average employer to handle, so all this bureaucracy created a business, a service, a big business service. Running a business isn't as simple as knowing that Joe Jones worked 40 hours at $10 an hour and is due $400. If it were that simple, Paychex and ADP wouldn't exist.

More Stickiness

CINTAS rents business uniforms. Again, not a sexy business. Until you hear the CINTAS story, you don't realize how many different industries have employees or businesses that rent uniforms. Employees wear uniforms on a day-in, day-out basis, getting them dirty, wearing them out. CINTAS generates revenue each and every day in a recurring fashion as opposed to a technology company that is selling a product and must keep selling that product, finding new people to buy it each day. Paychex, ADP and CINTAS have streams of revenue that are much more predictable because they are not dependent on new sales each day.

If somebody copies or surpasses a software company's once cutting-edge product, then its sales fall off the map. CINTAS has a service for small and medium sized businesses where it charges a fee to these businesses to take care of the uniforms for their employees. And as long as the businesses that CINTAS is working with are growing businesses, it guarantees a built-in growth mechanism. CINTAS signs up new businesses, but there is a recurring nature to its business that is different than selling things each day.

As long as they don't screw up, people will be with Paychex and ADP year in and year out; payroll is a big recurring revenue business.

America Online operates on a similar, even stickier model: a subscription service. People tend to stay with the service unless they are unhappy with it, and there will always be people who are unhappy and leave. But it is still easier to start out your year with 90 percent of your revenue intact. And most Internet virgins sign on here for their first taste of the Web because AOL ­ and its free disks offering hundreds of free online hours ­ are ubiquitous in our culture.

There is an adage about technology companies, that if you must ship a box to get paid, that makes it a different business than one where you contract on a monthly subscription basis to get paid.

AOL is a business that collects $21.95 every month from its members for unlimited access, and people pay that monthly bill just like the telephone bill. It is one of the last things that anyone would default on; many will pay for their electricity, rent and their AOL. So the ISP model that AOL pretty much pioneered is a good business model.

And with so many customers paying for AOL by credit card, they don't even have to lift a finger. As such, AOL probably gets paid ahead of everyone else.

There are two ways to look at sticky business. One is that it has compelling reasons for customers to stay with it. They can't switch easily. That is the more conventional meaning of sticky business.

AOL's stickiness is more embedded in the fact that people really don't like to change operating systems and ISPs because it is such a nuisance. So as long as AOL does a competent job, it will keep most of its customers.

Whether it was Steve Case or someone else, somebody at AOL understood the value of convenience early on. Convenience is productivity. One of the secrets of AOL's success is that it made the Internet convenient. Businesses that offer services that are easy to use are reaching out to their customers. Their customer doesn't have to make as big an effort to use their product. That is a good business philosophy. It has been the Wal-Mart philosophy: why make somebody go to another place to buy something when we could sell it in our store and they are already there? So Wal-Mart keeps growing its long list of SKUs and services, bringing in bank branches, one-hour photo service and mini-McDonald's.

McDonald's itself is an excellent example. Its empire building began with hamburgers, fries and Cokes. McDonald's didn't originally offer breakfast ­ that came a few billion burgers later. Then management figured out that it had all these assets in place and could create traffic at more times during the day. That meant convenient service for its customers while generating a better return on fixed capital.

Breakfast was one of the last great re-inventions of that company. It took a lot of planning, and listening to customers. But that is what good management is about.

Northern Trust fits the sticky business model as well. A large part of its business is personal trust, so that when a wealthy family establishes a relationship with Northern, the bank gets a fee based on the assets under their management. The fee is based on the daily amount of assets under management, and that fee will generate revenue year after year. The revenue is sticky in the sense that people tend not to change their personal trust relationship from one year to the next year. They will not shop around. Unless they get horrible service from Northern, they will probably stick not only year to year but maybe generation to generation. So the recurring nature of that revenue is high as opposed to a bank that is making a 30-year mortgage loan today, but if rates drop a year from now, the customer will refinance somewhere else. Plus, that mortgage is likely to be sold from bank to bank over the years.

The residential mortgage business is price-sensitive with low barriers to entry and low switching costs; personal trust business is a sticky, recurring revenue business. Even if a trust customer discovers that J.P. Morgan Chase's fee is 10 percent lower than Northern's, there is too much cost and aggravation involved in switching a personal trust account. Even if it means saving 10 percent a year for the next ten years; it is too much hassle for most people.

Discount brokerage is a price-competitive business, so when deep discount brokers such as E*TRADE and Ameritrade started up, the general consensus was that Schwab would lose its business. Why would someone pay Schwab $30 for a trade when they can do it with a deep discounter for $10 a trade? If you chose Schwab, you did it because you were price-sensitive, right? Well, the genius of Schwab is that it layered on services and a relationship that made it much less price sensitive. The customer found that with Schwab, he could consolidate all his mutual funds and financial assets, access it online and have 24-hour, 7-day-a-week customer service by telephone. That is a successful value proposition versus saving $10 a trade. If Schwab had stuck by its roots, it would have suffered dramatically from the arrival of the deep discount brokers. Instead, it became almost a ubiquitous presence in the life of its clients.

Schwab also relieved the stress of something that used to be a big hassle, switching from one mutual fund company to another. Ten years ago, it was a lot of paperwork. A client called the new mutual fund company and the old one, then crossed his fingers. Now, one phone call to Schwab or a few clicks online gets it done in two minutes with no paperwork, no signatures. You don't explain yourself to a salesperson who might give you a hard time over a decision that is none of their business.

Schwab transformed itself from a discount broker to an asset management company just in time, and in so doing, made its business much less price sensitive and much more of a recurring revenue model.

Still Sticky After All These Years

Sticky business is attractive because it represents more than just a one-shot sale. Not that you can't be highly profitable in that, but many people have an understandable bias toward businesses that can sail through the business cycle because of a recurring revenue stream; that is, people must use a company's maintenance, repair or performance service.

GE is largely a service company. By some estimates, as much as 75 percent of its revenue is service. In the plastics business, for example, it provides ongoing services such as inventory monitoring that tend to lock in customers. GE will fill up a client's inventory with ­ surprise! ­ GE product. In its locomotive business, GE generates huge amounts of revenue from servicing locomotives rather than just selling them.

In consumer products, this is known as the razor/razor blade argument.

Gillette sells razors at a marginal price. But think of all the razor blades it sells. By the way, you probably can put someone else's razor blades into the Gillette razor, but most people don't. And who will spend the $5 to find out? It is such a small item. Suppose it doesn't work? Then you have to toss it out. So most people stay locked in.

Kodak was once a great example of a company with recurring revenue. Use a camera? You need film. Or at least you used to.

When George Fisher left Motorola for Kodak, his impact was greatly anticipated. But no matter how good a manager, if you put him into a no-win situation, he will fail. At Kodak, Fisher was up against a serious timing problem. Simultaneously, he had an extremely profitable company with 70 percent gross margins, and yet the only place it could go was down. It was a flat market with a competitor, Fuji, that had deep pockets because it dominated the Japanese market. Plus, Fisher arrived at the same time the transition from emulsion film to digital cameras was picking up speed. Digital is a lot cheaper and doesn't even require film. So no matter how good George Fisher may be, he wasn't able to turn that one around.

He couldn't overcome the fundamentals, which were difficult and rapidly evolving. Who can build a gross margin above 70 percent? That's just about impossible. It is the "trees growing to the sky" business. If you are Intel, can you keep growing indefinitely at 30 or so percent a year? The answer is no. But counter-intuitive euphoria drives prices up.

Global Interests

Being a world-class competitor is another profitable benchmark of today's economy.

The first global brand in commercial and investment banking will likely be Citigroup. But no banking analyst expects ­ or wants ­ to see the National Commerce Financial Corporation in Memphis expanding into France. There are plenty of opportunities left for it in the United States. That would be out of character, a red flag.

Waters makes high performance liquid chromatography equipment for the pharmaceutical industry. Should it confine sales to the United States or even North America? Absolutely not, because some of the biggest global pharmaceutical companies are based in Europe and they need the same equipment that Merck or Pfizer or any of the U. S. companies do. Stepping overseas, for Waters, is a natural and logical progression. If it didn't recognize that opportunity, you would have to wonder why.

GE must go outside the United States to continue growing in many of its business units. The Procter & Gambles and the Coca-Colas of the world would be lost without the ability to push for growth in the international markets.

It is generally a positive for a company to have a global presence just from a growth standpoint; different markets are at different levels of maturing for different businesses.

For example, in wireless telecommunications, Nextel and BellSouth both have a big presence in South America. That is a real positive because in South America, less than 15 percent of households even have phone service, and the way most people there will get phone service might be wireless. Europe already has higher wireless penetration than the U.S. so an U.S. company might not see as much growth there. China, on the other hand, is a huge growth market for telecommunications, especially wireless. And also, economies grow at different rates.

Not that it's as easy as putting out a shingle and an American flag; the U.S. does not have a monopoly on innovation. A Japanese company reportedly has the most cutting-edge wireless services in the world and the most cutting-edge handsets and everything else. It is rolling out what is called third generation wireless service in Japan this year. We are years behind that.

When a company reaches outside the U.S., some analysts wonder whether it is motivated by slow domestic growth. It causes a measure of skepticism. It brings added risk. A lot of companies stumble when they expand overseas. It is more difficult to control, and there are foreign currency, culture and regulatory issues.

The Home Depot and Wal-Mart are pretty darn close to maxing out the United States for their stores, respectively, but many observers express concerns about how the dynamic duo will take their concepts overseas.

Execution and the structure of their expansions are important. A small company need not go global, but it could if it is appropriate. A large company, however, almost certainly should be on the worldwide map.

Equipment manufacturers and technology players are expected to be global, but too many rush off to open a London office before getting their feet firmly planted on terra firma in the U.S. China is still considered a high risk investment.

How deeply penetrated is a company in its global markets? How much of its growth is coming from global markets? Coca-Cola growth at home is absolutely flat and going nowhere, yet it has until recently been growing handsomely because it penetrated the rest of the world. You should know how good a company is at exploiting global markets relative to its competition.

A company with a growing and uncompetitive global market has a huge real option. But take away the weak competition part, and you discover entrenched competitors in all these markets. Whirlpool must deal with Electrolux, which makes building a strong position in Europe tougher. Even though it is a huge market, there are incumbents it can't push around.

Companies mislead investors pretty easily when it comes to overseas business and prospects because many Americans just aren't that worldly. If you invest in Africa, you will have to endure a lot of failures. And many overseas markets arbitrarily close sometimes. Or regulation gets in the way. Enron is a classic growth company, but it gets beaten up regularly in India. It sticks with it, trying to exploit that enormous market, but few Americans understand the Indian markets.

Sustaining reasonable share price growth means growing revenue and profitability in the range of 12 to 15 percent. The question for big companies is how much growth can they capture domestically and how much growth is required from overseas?

Ultimately, every company will look beyond the borders of the United States, not just for growth but to avoid the risk of getting blindsided in its home market by somebody who is developing strength overseas.

If a company is not pushing profit growth by 12 to 15 percent a year, it will be, by definition, in the lower half of shareholder value performance. The question is, how do you get it? Do you get it by merging in the United States and getting bigger and bigger or at some point begin looking internationally? In some industries, there is ample room for domestic growth; banking is one, and there are basic industrial products that can continue growing in the United States. There are others that have no choice but to begin thinking globally.

PepsiCo is a huge company with deep pockets, and yet it stumbled overseas. That puts a little fear into others that might otherwise feel bold about a move of their own.

And PepsiCo's primary global competitor, Coca-Cola, was sued in some of those countries for its anti-competitive behavior. But the real competitive issue was that Coke moved globally much faster than Pepsi did. The Coke brand subsequently became so powerful that Pepsi couldn't dislodge it. Coke saw that Pepsi was gaining it in the United States and aggressively mimicked some of Pepsi's own actions overseas, precluding Pepsi from getting an edge there.

Bear in mind that while an U.S. company is looking at global markets, companies over there are looking back at us. Look at what's left of the domestic steel industry. And all the U.S. television manufacturers from a generation ago are nothing more than Trivial Pursuit answers today.